Wall Street vs. sanity: Painting a clearer picture of AAPL

In the few days that have passed since Apple’s latest quarterly results, people can’t seem to stop writing about the so-called stalled growth and “margin collapse” that hit the company. Ok, the term “collapse” is excessively stupid (you know who you are, stop it). Apple’s revenue is still growing, but profitability is down year over year. The profit decline is due to undeniably lower gross margin. But what does that mean?

If you look at a the last 5 quarters and put it in graph form, it looks ugly. It looks scary. It makes you wonder why anyone would own the stock. And looking at 5 quarters is a pretty typical thing to do on Wall Street. People think of this as a longer term view of things, as crazy as that sounds. Apple just reported Q2, so looking at 5 quarters means you see Q2 from last year on the left, and Q2 from this year on the right.

Newsflash: Looking at a year over year comparison in isolation doesn’t paint a very clear picture of what’s really happening. And because Wall Street suffers from attention deficit disorder, it needs to form rapid-fire decisions on things.

Most analysts do not publish long term performance charts in their reports. I don’t know why, but it’s true. Sure, they all have the data in their models. They probably all have long term charts built in Excel, but they don’t get published.

Well, I’m publishing the one I keep in my model.

This chart goes back to Q3 2007, which is the first quarter of iPhone shipments. I could have gone back further, but I don’t think it would be as relevant because the business truly has changed ever since iOS was built.

So in blue we have a line graph representing revenue. You can see that it took a while for the iPhone to make a massive impact on the overall revenue, but in 2010 things just started to rocket upwards.

Then in the last two years, you can see that the holiday quarter has stood out as massively important. There have been two such holiday quarters so far, and they define the new peaks for revenue. In other words, Apple revenue has become much more seasonal. This means the quarters in between the seasonal peaks are less important. They are not unimportant. They are just less important.

Think of it this way. When you watch a storm build in the ocean, you can see each wave becoming bigger, crashing harder onto the beach. It doesn’t make a lot of sense to evaluate each wave on it’s way down. It makes a lot more sense to think about how high each wave crest goes. And right now, Wall Street is looking at a falling wave. Revenue could easily rocket higher again. China Mobile deal? Potentially a less expensive iPhone? Continued growth of the iPad, where sales nearly doubled year-over-year?

Now let’s look at gross margin, because this is what really has Wall Street bothered. I showed margin on the green bar chart, because somehow it just seemed easier to look at in bar format.

Apple had gross margin above 40% for 8 quarters since the iPhone launch. And a full 6 of these quarters were consecutive, from the March 2011 through to June 2012 quarter. For rear-view-mirror observers, it’s horrible to see that the gross margin peak happened in March 2012, which is the year ago quarter relative to this week’s earnings report.

But Apple does not have a history of margins above 40%. The mid to high 30% range is much more common, and it seems the company is moving back into that zone. Yes, the iPhone has higher margin than the Mac or even iPad. And that’s great. But I think we all realize that Apple can’t continue to gain global market share with a product that is out of reach for most global consumers.

So Apple has done the smart thing. They’ve taken more aggressive action on the iPhone 4 in places like China. It’s quite obvious that this makes the year-over-year margin comparison look like a case of Apple failure. But if you zoom out and look at the bigger picture, the margin moves really don’t look that shocking. If anything, it’s shocking to see how bloody high they climbed in the first place. This seems more sustainable.

And what if Apple had been more aggressive on pricing in the first place? The margin never would have climbed so high, and last year’s Q2 quarter never would have been as insanely profitable as it was. And we’d be looking at the most recent Q2 result saying, “Wow, Apple keeps growing. Amazing!”

The stock market is all about comparisons. And unfortunately, the comparisons are fairly short term in nature. But even the “fast moving” (I use that term loosely) technology sector requires a longer time frame for analysis. Apple did not build its iOS empire in a year, or even two years. Android did not grow to dominate the scene in a couple of years either. BlackBerry did not collapse in a year (and it’s potential comeback will not take one year). Things still move a lot more slowly than we all seem to think.

Apple is growing quite nicely. And if gross margin normalizes here, which seems reasonable, then next year we’ll be looking at a growth stock again. Everyone will forget about the supposed gross margin “collapse” that we apparently just witnessed.

Since I happen to have my DSLR camera beside me right now, this metaphor seems appropriate. You don’t need to constantly take pictures with your telephoto lens set to 300mm. Sometimes the wide angle shot is better, and provides more context.

Chris UmiastowskiChris was a sell side financial analyst covering the tech sector for over 10 years. He left the industry to enjoy a change in lifestyle as an entrepreneur, consultant, and technology writer.

You underestimate the power of fear -- especially in finance, most people weigh downside more heavily than upside. Fundamentally, the seeds have Blackberry's collapse may have taken more than a year, but that is small comfort to those holding stock during shocks in 2007 and 2008, when the stock lost most of its value in a few weeks. If you are afraid of being burned by a repeat, it is very easy to spin a parallel narrative like this:

"A large chunk of Apple's revenue rests in a single product line (iPhone) that has lost market share, and Apple seems unwilling or unable to figure out steps to stem those losses, despite unprecedented cash reserves that could be put to better use. If they cannot stop it, we could be looking at a repeat of the devastating consequences of Mac vs PC, and I do not want to be left holding the bag when the stock price *really* collapses, like those poor guys holding RIM stock a few years back."

Despite the myriad flaws in that story, it sounds *just* plausible enough to dissuade conservative investors. (Many risk-loving folks, of course, have already moved on in search of the next ground floor to get in on.)

Part of Apple's fundamental product strength is its focus on small number of lines, but there is always going to be a portion of Wall Street that views that as too many eggs in one basket, and fears Apple as too vulnerable to disruption to invest in, regardless of their current performance.

Re: "Many risk-loving folks, of course, have already moved on in search of the next ground floor to get in on."

Exactly. Oracle dominates the database and business software market. But is ORCL skyrocketing? No, and it won't. Oracle owns the RDBMS market, and they will never face a challenger that has any chance of disrupting their business. But Oracle is just part of the furniture now. No more sizzle.

The stock market is like a gigantic poker game. Experienced poker players know that game selection is the key to profitability. Sitting in a game with nothing but tough players means that you just might be the sucker.

You want to sit at a table full of suckers, who can and will make all kinds of mistakes. The classic "juicy game." Greedy and/or inexperienced investors make all kinds of mistakes when they invest in a company that is experiencing fantastic growth (Yahoo in the late '90s, Apple in the early '10s.) The difference being, of course, that poker players are intelligent enough to only shear the sheep, not skin them like Wall Street investors.

"You can shear a sheep a hundred times, but skin it only once."
- Amarillo Slim Preston

I don't see what the big deal is. The market price is just coming back in line with what it should be. 700 dollars a share was insane. If you bought then I am sorry for you. Maybe you have learned a lesson. Never board a ship that has already set sail, wait for it to return to the dock, which is exactly what is happening now.

I didn't buy at that price, but for those that did, it was bold but not insane. Remember, there were a good many price targets out there that were above $700. The only real thing that is insane are the uninformed analysts and speculators. Even at $700 the fundamentals were good and the stock was not overpriced.

Great article Chris, but I think your title says it all. Investment is based on rationality. The question is, will the bulk of 'investors' (ie: speculators) ever return to rationality? If not, then it doesn't matter how sound your analysis is, the stock price won't reflect it.

Do I have any doubt about Apple's performance, at least over the next 4 or 5 years? Not really. However, at this point, I have no clue where the stock price will head... and I don't expect it to match any kind of reality.

Steve - the market isn't reflecting it now because it reflects fear. Just like it didn't reflect the fear at 700 bucks. It will continue to act like a macro lens. It will never be right in the short term but always right in the long term.

I'm wondering if the bigger problem is that Apple hasn't opened a new product category in 3 years. Because of this, nobody knows what to expect. I think Apple could pull it off. I remeber asking what could Apple do when the iPod dies out? I would have never imagined the iPhone and iPad. But there was 3 years between theiPhone and iPad. We should be at that time now considering it's 3 years since the iPad. Hmmm....

I hope you're right, though I'm not that confident. Rationality, in economics is key. Rationality is quickly on the way out, in economics and otherwise. Hopefully that will change, but I see no signs of improvement at this point.

When it comes to AAPL, I've had a feeling that Wall St analysts and journalists have been making the mistake of following too closely tech journalists and bloggers. You can see it in the pop vernacular many of them use in their reports. While they should be listening in for hints, they're also falling victim to misleading, ad-revenue-driven headlines and content, followed by polluted comment sections full of anti-Apple remarks. If you were to perform AAPL research looking to forecast based on most Apple-related tech write ups in the past six months, it wouldn't be difficult to imagine Apple doom.

I really think that there isn't a clear answer at this point that's why the stock price looks so schizophrenic. Both views at this time appear logical. The problem is Tim Cook doesn't have an answer for the other side. One view is apple is quite dominant in developed markets, however the growth going forward is in emerging markets. If you look at this last quarter china was the market where revenue actually really grew. There are 2 problems for apple in china, one there phone is too expensive even the iphone 4 its $400+ phone, so even though they are growing in china it's small in relation to the larger market. Also the Chinese don't appear to be using the iTunes store that much, and there is a history of piracy in that market. It also appears that Samsung has more traction with their larger phones there. When asked about this on the conference call directly by a morgan Stanley analyst, Tim Cook didn't address the question, he side stepped it. Now apple has a lot of cash in the bank and could definitely redesign their business going forward for growth in emerging markets, however they haven't exactly said how they are going to do this. So there are 2 sides to this one is that they want to shove rather expensive phones that were designed for developed markets into emerging markets which may not be the best when you're competing against an open platform like android, or 2 they are going to design a product for this market. However until you see it you don't know, and I think is being reflected in the stock price, apple being such a secretive company and not telling you their roadmap doesn't help either, they keep tight lips and launch products, which really has worked fine for them in the past. Blackberry knew they had a problem with their os first denied it, then acquired a company qnx and took forever to get their redesigned product to market. All the while telling investors their plan and really their stock tanked because they didn't execute well. With apple going forward we won't really know till we see the products. I've been buying stock at these low prices, with the bet that they are going to be making products for emerging markets and really focusing in on that, however I have no clue if the company will do that, I think they will since Tim Cook has said China in the future will be one of their most important markets. I think that's why the stock is so cheap.

Perhaps the biggest question mark is where will Apple grow next? I agree with everything you said. Samsung has emerging markets in a bag. If you just look at China and India, you're looking at 2 billion+ potential customers. But Apple caters to a group of less than 100 million because of their prices.

Is Apple's revenue actually more seasonal, or does it just look that way because of greater absolute changes wrt the holiday quarter? Your graph would be more immediately informative if the revenues were plotted on a log scale so that the slopes of increase to, and decrease from, the holiday quarter could be compared from year to year.

At least the last couple of years the holiday quarter is the big quarter in the smartphone industry. So as the market matures i think it is becoming more seasonal that's why i think no summer announcement for a new product isn't a big deal. However what can happen is that there can be so much pent up demand it can be a problem for their supply chain

I think the biggest problem is that people WANT Apple to fail so much. Apple has already became that ''underdog'' story. It went from a flopping company to the giant it is today. Since it has completed that cycle and became the ''new'' Microsoft, people are awaiting its collapse.

People prefer the underdog because their money can grow considerly more and someone they can ''root for''. Especially since Mr. Jobs died, people think ''all the steam will run out eventually''. That's why you see companies like Samsung being the poster child for the next big thing...no pun intended. But it's like that.

The stocks will rise considerably with the iWatch's release. Then when it does not sale 20 million units in its first month, shares will collapse.

Since everything that has a beginning has an end, Wall Street will esssentially be ''right''. Apple will stop growing considerably. It has too. We have a human population limit. I mean, you can't really exceed 7 billion theoritcal units unless everyone bought two. Even then, since they only bought, they're going to feel like everyone should have bought 3.

My thinking is that Wall Street has hammered AAPL stock in order to buy large quantities of shares for when the price starts to rise again, so they can of course sell and make a profit. Short term profits versus long term investment potential. Get rich quick. Instant gratification.

The S (refinement) model has ALWAYS been more profitable then a new Model. Which means slightly higher Margin. So when those stupid analyst ( Actually they are not, as they are earning even more when AAPL are dropping, ) call out Apple has a dropping Margin to make a headline. Combine with what they report a so call Year on Year Profit Drop.

The problem is iPhone has been growing tremendously in the past few years where every New Model iPhone actually outsells the previous refinement models. So while new model earns less then the Refinement model, for the past year the growth cover up with the less margin new model, making Apple having a Profits increase Year on Year.

Since iPhone is aim only at the top end, high margin market, this year the growth has slow down a bit. It is a few things, the higher end market is becoming mature, people with last year or 2 year model aren't as eagerly to upgrade, completion from other players.

But the market continue to make a big fuss about it. Apple were never priced as a growth stock. Even when it was rapidly growing its P/E were only ever 13 to 14. But even if Apple aren't declining it still isn;t valued right either.

My bet is that Apple is just such a valuable stock to hold. Analyst knows it may be too well, even better then we do. And there are simply too much free money flowing around on the market, with no clear safe bet to be made, they had to make Apple's price cheaper in order to buy more.

interesting tidbit, Samsung has >50% marketshare than apple, but has half the profits of apple because they are gaining market share in emerging markets and killing apple there. However apple is a software company too, so one way to make money is make more money of your existing customers in developed markets from software services or a new product, or produce a product for emerging markets to gain market share. The only way the share price makes sense if you think that Samsung is going to start outselling apple in the markets where they are leaders in such as the states. If you think this is the case you shouldn't buy the stock as there is no floor. The stock is being priced like a dell or hp, which is pretty crazy as they relied on Microsoft for their software. Apple has an intergrated solution with software and hardware that makes it worth the higher price. Samsung is getting most of their growth from china, that can turn on a dime as the Chinese government could turn on a dime and start supporting local makers such as Lenovo, they all use android. Samsung is at a P/E of 15 I believe while Apple is at a P/E of <10... I personally think the sentiment is insane

AAPL is no longer a growth stock. The Street pushed this thing up way too high too fast over such a short amount of time. IMOP it should be trading around $365 - $405. They really have no advantage over other hardware companies (and yes they are a hardware company).

You want to see innovation look at what LG is doing. They don't spend enough in marketing, but their products are way better than Sammy's. I think AAPL should buy them.

But then Cook said something really interesting.
Because we're not a hardware company, we have other ways to make money and reward shareholders," he said.

Cook pointed out that Apple's software and services business—iTunes, the App Store, iCloud, and other all-digital offerings. That's large even compared to most pure-play software and services companies, he observed.
"There are other things we could do to have revenues and profits flow," Cook said.